Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

IMF Survey: Health of Japan's Financial System Tied to Growth, Government Debt and Deficits

August 1, 2012

  • Policies after crisis in 1990s, early 2000s helped secure financial stability
  • Risks to financial sector from large exposure to government bonds, slow economic growth
  • Reforms essential to improve credit growth

Japan’s financial system is at a critical crossroad: more stable than a decade ago thanks to reforms after a protracted period of economic crisis and financial stress, but banks’ large holdings of government debt and slow economic growth are challenging the profitability and functioning of the financial system.

Health of Japan's Financial System Tied to Growth, Government Debt and Deficits

Banking at ATMs in Tokyo, Japan: the country is an example of how overall health of the economy, financial system are connected (photo: Andy Rain/EPA/Newscom)


Deep-rooted issues need to be addressed that pose risks to financial stability: long-term fiscal sustainability, deflation, and the impact of the country’s aging population on growth and private savings, the International Monetary Fund said in its latest assessment of the country’s financial system under the Financial Sector Assessment Program.

Swift and decisive policies have helped maintain financial stability, including in the wake of the earthquake and tsunami in 2011, but Japan needs to strengthen systemic risk monitoring and crisis management policies, and further reform the oversight and supervision of nonbank financial institutions.

“Japan is a prime example of how a country’s overall economic health and its financial system are so closely connected,” said Udaibir Das, an Assistant Director in the IMF’s Monetary and Capital Markets Department and head of the team that conducted the assessment. “A broad-based plan for financial reform could help Japan create an environment that enables private sector-led growth alongside an ambitious, multi-year reduction in government debt and deficits. Our assessment has offered a number of ideas to strengthen micro-and macro-prudential oversight, and called for financial reforms to gradually reduce the role of the government in the credit channel.” 

Changes in financial system helped weather global crisis

Japan is one of the major 25 financial centers that since 2010 are required to undergo an in-depth review of their financial health every five years under the Financial Sector Assessment Program as part of the IMF’s surveillance.  Japan’s last assessment was in 2002.

Since 2003, large banks and insurance companies have restructured to improve financial soundness, reduced nonperforming loans, and strengthened their capital positions considerably. Also, Japan enhanced its oversight and regulation of the financial system, and greatly improved its ability to manage banking crises. As a result, the system was able to weather the global economic crisis that began in 2008, and is well positioned to implement the new international banking standards, known as Basel III.

“It is remarkable that Japan’s financial system could withstand so well one of the most severe output contractions experienced among the Group of Eight advanced economies during the current global crisis,” said Nicolas Blancher, an Advisor in the IMF’s Monetary and Capital Markets Department and deputy head of the assessment team.

Main risks

Currently, Japan’s financial system appears resilient to severe economic distress and moderate market shocks. However, long-term fiscal pressures, deflation, and slow growth are risks to the stability of the financial system. In particular:

• The financial system’s massive holdings of government bonds leave it exposed to a spike in market yields, from levels that are close to zero;

• In the absence of sustained economic recovery, bank profitability may remain weak and credit risk may rise;

• While growing overseas exposures of Japanese financial institutions is a positive step, it calls for stronger financial oversight, including cross-border supervisory collaboration;

• Several regional banks have thin capital buffers, concentrated exposures to weak local economies, and relatively large holdings of long-term government bonds, which make them vulnerable to slow growth and market-related shocks.

Key reforms

In its assessment, the IMF recommends a series of near-term reforms, including the following:

• More regular information sharing, risk monitoring, and inter-agency coordination of policies across all types of financial institutions;

• Carrying out more thematic and bottom-up stress tests, in particular to address credit risk concentration and cross sectoral interconnections;

• Further improving the quality of prudential supervision, including through more stringent limits on banks’ large exposures, higher minimum capital ratios for domestically active banks, tighter risk-based solvency requirements for insurers, and improved registration and auditing requirements for securities firms;

• Stronger crisis resolution mechanisms for systemically important nonbank financial institutions.

Also, once the economic recovery is on a more sound footing, further and well-sequenced financial reforms—that will need to take into account the ongoing demographic shifts in Japan—should be undertaken to increase the participation of the private financial sector, support market-based credit allocation to small and medium-sized enterprises, and deepen capital markets.

2012 is a busy year as the IMF evaluates 18 countries’ financial health—ranging from Mexico and France to Angola and Nigeria—to identify vulnerabilities and suggest measures to better anticipate problem areas and mitigate spillover risks. In each assessment, the IMF produces a detailed report that includes recommendations for the country on how to strengthen its financial stability framework, including based on evaluations of its compliance with international financial sector standards.